An economic analysis of tradeable emission permits for sulphur dioxide emissions in Europe

7.1 IntroductionThis study has examined the question of whether a system of tradeable emission permits can contribute to a cost-effective reduction of SO 2 emissions in Europe, taking into account prespecified deposition targets and what sort of system it should be. To deal with this question three research topics have been examined.(I) What are the main economic aspects of a European acid rain policy?(II) What are the advantages and the disadvantages of using a system of tradeable permits to implement a European acid rain policy?(III) What should a system of tradeable emission permits for a non-uniformly mixing pollutant look like in order to take deposition targets into account?This chapter summarizes and presents the conclusions of this research. First 1 present the conclusion on the efficacy of the different integrated assessment models in analysing the effects of emission reduction. I then summarize the conclusions on guided bilateral permit trading. Finally, I make several suggestions for further research.7.2 Economic theory of pollution controlIn this research I have followed the ecological approach to pollution control. This approach does not aim at optimal pollution control levels where marginal abatement costs equal marginal benefits. Marginal benefits are usually too difficult to determine. Instead it aims at cost-effective abatement of pollutants to reach prespecified enviromnental targets. Since acid rain is an international environmental problem, cost- effective abatement needs to be considered in an international context. To achieve cost-effective international abatement it is necessary to have cooperation among countries. Although full cooperation results in minimized total costs for the cooperating countries, individual countries may, however, not act accordingly. This has been explained by the existence of the prisoner's dilemma. However, the assumptions underlying the prisoner's dilemma do not always hold in reality, and in the real world, countries do have some incentives to cooperate. Moreover, side payments can be introduced to stimulate countries to participate in cooperative abatement strategies.Another issue I discussed is which policy instruments can be used to implement pollution control policy. A main distinction can be made between economic and non- economic instruments (regulation). A main advantage of economic instruments is their cost-effective character because, unlike regulation, economic instruments result in minimum control costs. Moreover, they allow more flexibility to the polluters and provide a continuous incentive for developing and adapting new control technologies. This thesis has elaborated on the use of tradeable emission permits.7.3 Tradeable permits for non-uniformly mixing pollutantsEnvironmental degradation by non-uniformly mixing pollutants depends not only on the amount of emission, but also on the location of that emission. Accordingly, the environmental aim I followed in this study was not to reach an emission target, but rather to reach deposition targets. This has main consequences for using a system of tradeable emission permits as this system, in principle, only regulates emissions. It does not take the resulting depositions into account. The implications of permit trading for non-uniformly mixing pollutants have been illustrated and the alternatives for taking emission location into account in permit trading, that were put forward in the literature were discussed in Chapter 3.It cannot be concluded in general that emission permits are a suitable instrument for controlling non-uniformly mixing pollutants. The use of emission permits results in a cost-minimum reduction of emissions, but the enviromnental implications of this emission reduction are uncertain, as deposition may be unacceptably large at some locations. To what extent the resulting cost-effective emission allocation deviates from the cost-effective deposition allocation depends on the source-receptor relationships and the marginal control costs of controlling the sources. In the USA, however, tradeable emission permits are actually used for the non-uniformly mixing pollutant SO 2 . Nevertheless, one should be aware that this emission trading does not focus on reaching a deposition target, but is only emission oriented. Environmental targets are taken care of by State Implementation Plans in the USA.Deposition permits are an obvious alternative to emission permits for taking emission location into account. Theoretically, the use of tradeable deposition permits results in a cost-effective allocation that meets deposition targets. According to this system, sources have to own the appropriate number of deposition permits for each receptor affected. In this way authorities can control deposition targets. However, a disadvantage of this system is that it may result in an increase in emissions, which is politically delicate. Another argument against this system is the trading complexity that occurs because sources have to operate simultaneously in many different markets.Since the use of both emission and deposition permits is not considered to be a very suitable instrument, several alternatives permit systems for non-uniformly mixing pollutants have been proposed in the literature. Relatively simple alternatives are permit trading within zones and the 'worst case' approach, but unfortunately, these systems do not guarantee the non-violation of deposition targets.A promising permit trading system that does not violate deposition targets seems to be a more advanced one where the trading is subject to rules. Three variants are known: the pollution offset, the non-degradation offset and the modified pollution offset. All systems guarantee non-violation of deposition targets. The constraints on emissions and on deposition targets, however, differ between these systems. The pollution offset offers the largest trade opportunities, but allows for an increase in emissions. The non-degradation offset and the modified pollution offset are more restricting and consequently result in higher abatement costs. Which of the two has the lower cost cannot be shown on theoretical grounds.In judging permit trading systems, special attention has to be paid to the nature of the trading process. Although many studies implicitly assume a simultaneous trading process, it seems more reasonable to consider permit trading as a bilateral and sequential process. Combining permit trading subject to rules with the bilateral and sequential trading concept sheds new light on the cost-effectiveness of these permit trading systems. Empirical studies indicate that bilateral permit trading applying offset rules do not result in cost-effective abatement. However, bilateral and sequential trading has only been recently applied to studies on permit trading, and has been examined further in this study. A main conclusion is that permit trading for non-uniformly mixing pollutants has to be restricted in some way if deposition targets are to be taken into account. What is needed are restrictions that result in non-violation of deposition targets, and at the same time, do not hamper the attainment of the cost-effective allocation.7.4 Integrated assessment modelsIntegrated assessment models can be used for quantifying the consequences of abatement allocations. These models provide a scientific basis for evaluating alternative abatement allocations and are therefore a useful tool in policy making. Three integrated assessment models are available for Europe : (i) the Regional Acidification INformation and Simulation model (RAINS); (ii) the Abatement Strategies Assessment Model (ASAM) and (iii) the Coordinated Abatement Strategy Model (CASM). Integrated assessment models provide information on emissions, abatement costs, the atmospheric transport of emissions and the environmental effects of alternative abatement strategies. Since accurate monetarization of enviromnental damage is very difficult and complex in practice, the environmental damage is expressed in physical terms. For acidification, the environmental damage is expressed in exceedance of critical loads. Given these targets, a cost-effective emission abatement policy can be found. This makes these models very useful for policy analysis.Among the European integrated assessment models, the RAINS model is the most complete and extensive. Although the RAINS model, the ASAM and the CASM are roughly similar, they diverge on various points as well. One difference is the number of acidifying compounds they take into account. Other differences are the optimization options that are implemented and the accuracy of the emission location. Finally, the data sources used differ in some submodels. The main benefit of the ASAM is its accuracy on emission locations and the resulting atmospheric transport. However, because of lack of data for this purpose, the intended accuracy is only partial. Model results show no significant differences caused by the grid to grid approach used. A serious drawback of this model is the lack of clarity of the procedure needed to derive the so called Best Economic Environmental Pathway. The CASM is attractive because of its large number of optimization criteria. However, since policy aims at reaching certain deposition targets, optimization criteria to minimize environmental damage, given a budget constraint are not actually very useful for policy purposes. Comparison of the CASM and the RAINS model shows that the model results are broadly in line with each other.There are two reasons for the current status of acceptance of the RAINS model. First, the model is the most completely integrated assessment model for acidification. The alternative integrated assessment models, the CASM and the ASAM do not substantially improve the RAINS model. Second, RAINS was developed by scientists of various disciplines at an international "East-West" institute. This aspect mainly played a role in the acceptance of RAINS in international policy making (Hordijk, 1991, 1995). Acid rain models have substantially increased knowledge of the acid rain problem and have provided useful information for assisting and improving policy making. In this research I used the RAINS model for calculations. The reasons for this choice were those given above: (i) the model is the most complete one for acidification and (ii) the model is widely accepted and was used in the international negotiations on the Second Sulphur Protocol.7.5 Guided bilateral trade7.5.1 TheoryResearch has shown that in case of non-uniformly mixing pollutants, permit trading has to be constrained if a cost-effective emission allocation is to be attained. It has been argued that if permit trading is constrained, it is necessary to consider permit trading as a bilateral process. In Chapter 5 I developed a new system for bilateral permit trading describing it as guided bilateral trade. The aim of this system is to provide large trade opportunities while at the same time preventing the violation of deposition targets. However, it is not necessary to require that every trade transaction meets the deposition targets. A subsequent trade transaction might compensate for the deposition exceedance at a receptor brought about by a previous trade transaction. To be able to take care of the deposition targets, the guided bilateral trade system restricts trading by a trade vector which indicates the number of permits sources are allowed to sell or buy.Guided bilateral permit trading achieves a cost-effective allocation if all trade transactions that are in accordance with the trade vector are profitable. A drawback of guided bilateral permit trading is that trade transactions are not necessarily profitable. Whether this is so depends on the source-receptor relationships, the abatement cost functions, the deposition targets and the initial permit distribution. To reach the deposition targets ultimately, non-profitable trade transactions need to be compensated in some way. Before trade transactions can be guided to the costeffective emission allocation, this allocation has to be known. Therefore full information is required by the trade institution in order to establish the trade vector. Unfortunately, this cancels out one of the characteristics of tradeable permits, namely that full information is not needed. Knowledge on the costeffective emission allocation by policy makers might cause the guided bilateral permit system to become unnecessary. However, knowing this allocation does not by definition imply that it will be agreed upon at once, as can be seen from the Second Sulphur Protocol. In that case, a suitable instrument for achieving further cost savings is a system of guided bilateral trade.The term guided bilateral trade indicates that the permit market as such is not able to generate the desired outcome. The trade process has to be guided by a trade institution that takes care of the number of traded permits. However, any trading system that takes deposition targets into account will need some kind of control. The main advantage of the guided bilateral trade system is that the costeffective emission abatement allocation can be achieved if all trade transactions are profitable, or, if not, when non profitable transactions are subsidized. In the past, achieving the cost- effective allocation was thought to be possible by means of a simultaneous trade process. However, as I indicated in section 5.3, the practical functioning of such a trade system is a black box. This box can be opened by means of the system of guided bilateral trade.7.5.2 Simulation resultsTo examine to what extent the guided bilateral trade system results in a costeffective reduction of S02 emissions in Europe, taking into account deposition targets, I used the RAINS model to simulate guided bilateral permit trading among European countries for SO 2 emissions. In calculating the cost-effective emission allocation, emission is measured at national level. Accordingly, guided bilateral permit trading only allocates emission reduction between countries. The way in which countries meet their emission reduction is a next step. For the sake of completeness it should be noted that the European abatement allocation is only cost-effective if all individual countries also reduce their national emissions in a cost minimum way. I simulated guided bilateral permit trading for three cases. In the policy oriented Base Case, permit trading aimed at the cost-effective emission allocation, given the Current Reduction Plans of the European countries. In variant 1 the restriction of Current Reduction Plans was released. Variant 2 examined guided bilateral permit trading, starting from the SO 2 Protocol.The simulation results indicated that permit trading steers the trade process towards the cost-effective allocation of emission abatement, but the cost-effective allocation of emission abatement will not be fully reached by profitable trade transactions. In all three cases, the profit generated by guided bilateral permit trading was substantial. In the Base Case and in variant 1, the cost saying of permit trading amounted to 13.5% of the total abatement costs. From a policy point of view, variant 2 is very interesting since it draws heavily on the actual situation in Europe. The simulation result of Variant 2 indicated that guided bilateral permit trading, starting from the emission allocation in the Second SO 2 Protocol, results is a cost saving of 7.8% of the total abatement costs. Given this result, we may conclude that, compared to the SO 2 Protocol, some cost-effective improvement is possible by guided bilateral permit trading. However, it should be noted that the simulation results excluded transaction costs. Therefore, the indicated cost savings can be regarded as the upper limit of possible savings.The simulation results indicated that the trade sequence influenced the generated profit. However, the simulations showed that the impact of trade sequences on the profit level was small. This suggests that a trade coordinating institute does not have to play an active role in the matching of trade partners, but only has to control whether countries trade according to the trade vector.Having discussed the main aspects of this study I now want to turn to the third research question. By developing the guided bilateral permit trading system I have shown how a permit trading system for non-uniformly mixing pollutants could be formulated that takes deposition targets into account. The main drawback of this system is that full information on the cost-effective allocation is needed by the environmental authorities if such a trading system is to be successfully implemented. But, it should also be realized that in the current practice this information has already been used: in the negotiations on the Second Sulphur Protocol the information on the cost-effective emission allocation provided by the RAINS model served as a guideline for the agreed emissions reduction. Since countries agreed upon the emission reductions in the Second Sulphur Protocol, they might agree on a permit trading system that is based on the same information.7.6 Guided bilateral trade revisitedIn this study I have been extensively illustrated that aiming at deposition targets for acidification while minimizing abatement costs is a complex matter. It depends on three factors: the source receptor relationships, the deposition targets and the differences in marginal abatement costs. Obviously, a policy instrument that is designed to generate a cost-effective abatement allocation needs to deal with this complexity. After having analysed the system of guided bilateral trade for SO 2 emissions in Europe thoroughly, the final question that has to be looked at is whether this system would be suitable for implementation in practice and how it could be introduced. This question is discussed in this section, paying attention to cost effectiveness, innovation, international agreements, implementation costs, distributional effects and practical implementation.The system of guided bilateral permit trading succeeds in reaching the cost-effective abatement allocation if all allowed trade transactions are profitable. If not, the cost- effective allocation will only be fully reached if the trade transactions needed to reach this cost-effective allocation are subsidized. This will be difficult since it is necessary to prune away profits from profitable trades to generate funds for subsidizing. However, the simulation results of guided bilateral permit trading indicate that the violation of deposition targets is only very moderate if the costeffective allocation is not fully reached by guided bilateral permit trading. Therefore it can be stated that guided bilateral permit trading is sufficient for the cost-effectiveness criterion. Arguments generally favouring the use of tradeable emission permits are that the use of permits provides a continuous incentive to search for technology innovation and provides flexibility to polluters in the way they want to comply with the environmental targets. Guided bilateral trade provides this incentive and flexibility as well.An important aspect in judging the suitability of guided bilateral permit trading is the conformity with international agreements. In this thesis 1 have shown that given the Second Sulphur Protocol, guided bilateral permit trading can improve the cost- effectiveness of emission abatement. Whether a system of guided bilateral permit trading will really be successful will largely depend on the willingness of the European countries to accept the specified trade rules and the initial distribution of permits. A disadvantage for negotiating countries may be that emission permits, by definition, put a price on pollution that was previously free. To make permits acceptable, countries first have to receive permits for free. In this thesis it was suggested that the agreed emission levels from the Second Sulphur Protocol could serve as a guideline for the initial distribution of permits, since countries have already committed themselves to these amounts. In fact, given the current sulphur protocol, the guided bilateral permit trading system provides a 'recipe' for reaching the cost- effective sulphur dioxide allocation in Europe. Since the sulphur protocol is an agreement among national governments, permit trading among these governments is an obvious succession. However, alternatively, a system could be implemented in which permit trading could take place among firms (see section 7.7).The costs of implementation of a guided bilateral permit trading system have not been studied in this research and it is therefore difficult to judge the system on this criterion. However, compared to the current international practice of negotiations, there seems to be no indication so far that the costs of this trading system will be substantially higher. Neither the distributional aspects of guided bilateral permit trading have been dealt with extensively. In general, no country will be worse off with permit trading, since a country will only trade permits if this results in a profit, resulting in a Pareto improvement. A country selling permits will only sell permits if the permit price exceeds the marginal abatement costs, and a country will only buy permits if this is cheaper than emission abatement. So, in so far as the abatement costs of countries change as a result of permit trading, this change is always compensated by the buying or selling of permits. Therefore, guided bilateral permit trading will only result in very moderate distributional effects.The most obvious way for practical implementation of guided bilateral permit trading is to extend the Second Sulphur Protocol with a guided bilateral permit trading scheme in an additional annex, in accordance with annex II in which the current committed emission reductions are stated. Currently, countries are obliged to report the annual levels of sulphur emissions to the Executive Body of the Convention each year. Likewise, countries could be obliged to report their trade transactions annually. I suggest that it is better to include a trade scheme in the protocol rather than the trade vector, since a trade scheme as presented in Table 6.15 or 6.16 results in the largest cost savings. Furthermore, by presenting a trade scheme, countries do not have to search for their trading partner. This form of implementation does not require the establishment of a new agency since it fits into the current international negotiation arrangement on acidification, through the Convention under the Economic Commission for Europe of the United Nations.In this section I have indicated that guided bilateral permit trading principally offers a suitable supplement to the sulphur protocol for reaching a cost-effective emission allocation. I have also indicated how such a trading system could be implemented. Remembering that the simulation results showed that guided bilateral permit trading may generate a cost saving of 143 million DM, this system can be taken as a suitable policy instrument for reducing sulphur dioxide emissions. Whether it can really be successfully implemented largely depends on the political willingness of countries to accept such a trading scheme.7.7 Suggestions for further researchMany aspects on tradeable emission permits have been examined in the literature. In this thesis I have emphasized the application of such permits to non-uniformly mixing pollutants for which a bilateral and sequential permit trading has been developed. This research could be extended to include topics such as banking of permits or market power. Additional suggestions for further research include (i) the aggregation in permit trading, (ii) the enlargement of permit trading to total acidification and its relation to other environmental problems, (iii) permit trading in relation to other environmental problems ensuing from common sources and (iv) the implementation of guided bilateral permit trading where there is no protocol.(i) In this study I have assumed permit trading takes place among national governments. One justification for this is that a permit trading system has a fair chance of being accepted if it is close to the current multiparty negotiations that assign targets to nations, as in the sulphur protocols. An alternative would be that emission permits be distributed to and traded by firms. Arguments in favour of this are that national governments lack experience and lack knowledge about operations and compliance options at the firm level. The question is what guided bilateral permit trading would look like if trading took place among firms. Although the general methodology of guided bilateral permit trading needs no modification, if trading is taking place among firms rather than among countries, its implementation requires additional research. To simulate permit trading among firms, additional data are needed. The source receptor matrix has to be adapted since it is the location of firms that matters now. The source receptor matrix has to link the firm's emissions to deposition, Moreover, abatement costs have to be specified at the firm level. The current RAINS-Europe model does not contain these necessary data and refinements. However, the RAINS-Asia model, a policyoriented model which provides a framework for integrated assessment of acid deposition in Asia, does already provide an analysis for large point sources. In this model, the emissions of 355 large point sources are linked to deposition at 1°x 1° grid cells (Foell et al., 1995).Alternatively, permit trading between firms could be analysed by a 'two-stage method'. This method, which needs no modification of the source receptor matrix, consists of first selecting two trading countries and next of selecting the firms with the lowest and the highest marginal control costs within these countries. Obviously, the firm with the lowest marginal costs is selected for the country selling permits and the firm with the highest marginal costs for the country buying permits. The next trade would be between the firms with the second highest and the second lowest costs, and so on.(ii) Acidification is not only caused by sulphur dioxide emission, but also by nitrogen oxides and ammonia. Instead of analysing trade in of sulphur permits, as I have done in this thesis, it would be interesting to study the opportunities for the use of tradeable permits for total acidification. This multipollutant approach is in accordance with the ongoing negotiations on a following protocol on acidification. However, it requires additional research, including the following topics. Firstly, the three pollutants contribute in a different way to acidity. This would lead to possible substitution of emission reduction. Further, spatial patterns of emission and deposition differ, and abatement-cost functions show differences. These differences imply that permit trading for total acidification will be complex, but considering all acidifying emissions simultaneously may provide additional cost savings. An interesting topic to analyse in this context is how to allocate the emission reductions of sulphur dioxide and nitrogen oxides as the latter contribute both to acidification and to tropospheric ozone. The role of nitrogen oxides in acidification has been discussed in Chapter 1. Tropospheric ozone is formed by complex chemical reactions of volatile hydrocarbons (VOC) and nitrogen oxides. The ratio of VOC and NO x , and not merely their total amounts, is important for ozone formation. This implies that when the ratio of VOC to NO x is very small, reduction of NO x , can actually increase ozone formation. In general, the abatement of nitrogen oxide is more expensive than the abatement of sulphur dioxide. This implies that a shift from nitrogen oxides to sulphur dioxide emission reduction would result in cost savings. However, as nitrogen oxides contribute to tropospheric ozone, preventing high ozone concentrations might, in some cases, prohibit the reduction of nitrogen oxides. An additional restriction on NO x emissions would be needed to take this into account in a permit trading system .(iii) A third extension of guided bilateral permit trading for sulphur dioxide emission would be to link sulphur dioxide emission to climatic change. The rationale for this is that both problems have a common source, that is, energy use. In the RAINS model for Europe which was used for this study, only end-of-pipe technologies are available for reducing emissions. However, changes in energy use may be of benefit to both acidification and climatic change. To analyse the effect of changes in energy use for sulphur dioxide emissions the RAINS model should be extended with an accurate energy scenario module. The RAINS-Asia model is already equipped to generate energy scenarios. The so called energy scenario generator in this model estimates energy consumption contributing to SO 2 emissions (Foell et al., 1995).(iv) A final topic for further research is how to implement a system of guided bilateral permit trading if a protocol had not yet been signed. Given an agreed initial permit allocation and given the restriction of the trade vector, it would be obvious to provide the opportunity to trade emission permits. Countries will have a strong incentive to trading since this is beneficial in terms of costs. If it appeared that countries would not trade, this could be an indication that transaction costs are too high. If transactions costs exceeded the indicated cost savings, permit trading would not take place, and countries would comply with the emission reduction without trading.It has become clear that research on tradeable emission permits for sulphur dioxide emissions is an interesting topic that needs further investigation. Extending the research by the suggested options may provide new insights into how to achieve emission reductions at minimum abatement costs. Especially growing economies, such as those in Asia and Latin America, that will suffer from sulphur dioxide emissions and deposition in the near future, can benefit from a better insight into tradeable emission permits for reaching cost-effective reductions.